Measures of Economic Activity

By Michael Donnelly, Matt Bundas, Andrew Wong and Neraj

Bakshi

Chapter Focus

Gross Domestic Product (GDP), and the two approaches to calculating it

The components of GDP

Per capita GDP, and how it may be used to compare GDPs of different years or different countries

Chapter Focus Cont.

Some limitations of GDP as an economic indicator

Other economic measures developed from the national income accounts

Recall

Recall that businesses track revenues and expenditures in their accounts thereby allowing managers and owners to pinpoint ways improving a businesses performance

Statistics Canada keeps track of the Canadian economy via national income accounts

National Income Accounts

Accounts showing the levels of total income and spending in the Canadian economy

Allow us to evaluate the performance of the Canadian economy and to compare it with other nations’ economies

Help government policymakers find ways to improve the economy

Gross Domestic Product (GDP)

The total dollar value at current prices of all final goods and services produced in Canada over a given period (usually a year)

Used to measure economic activity and can be developed from the national income accounts

The dollar value is used when calculating GDP because it simplifies the calculations

Also because the dollar value is a way to quantify and combine a wide range of goods and services

How to Calculate GDP…

There are 2 ways to calculate GDP:

1. Income Approach: a method of calculating GDP by adding together all incomes in the economy

2. Expenditure Approach: a method of calculation GDP by adding together all spending in the economy

The GDP Identity

GDP calculated as total income is identical to GDP calculated as total spending

GDP expressed as total income ≡ GDP expressed as total spending

This applies to the entire Canadian economy, not just the simplified economy shown in Figure 10.2

Breakdown of Figure 10.2

In short, because all spending on final consumer products ends up as some form of household income, annual income equals annual spending

This explains the GDP Identity

Breakdown of the Income Approach

Made up of 7 categories

1. Wages and Salaries

2. Corporate Profits

3. Interest Income

4. Proprietors’ Incomes and Rents

These form the basis of GDP calculated using the income approach

Breakdown of the Income Approach Cont.1. Indirect Taxes

2. Depreciation

3. Statistical Discrepancy These are added on by Statistics Canada in order

to balance GDP calculated by the income approach with GDP calculated by the expenditure approach

Using the income approach, GDP is the sum of all 7 categories

Wages and Salaries

Largest income category

Represents close to 60% of GDP

Includes direct payments to workers in both businesses and government as well as employee benefits such as contributions to employee pension funds

Corporate Profits

Includes all of the profits declared to the government by corporate businesses such as the profits paid as corporate income tax, the profits paid out to corporate shareholders as dividends and retained earnings

Retained Earnings: profits kept by businesses for new investment

Interest Income

Includes interest paid on business loans and bonds and income such as royalty payments (the latter occurring less frequently)

Includes adjustments to the value of businesses’ unsold products

Does not include interest payments made by consumers and government because these are viewed as transfers of purchasing power

Proprietors’ Incomes and Rents

This includes the earnings made by sole proprietorships, partnerships, self-employed professionals, farmers as well as the income to landlords from renting property

Recall that incomes are received by owners of proprietorships for supplying various types of resources to their business

Indirect Taxes

Taxes that are charged on products rather then be applied to households or businesses (i.e.: P.S.T)

Not included in the GDP with the income approach, but rather with the expenditure approach

To balance the results from the 2 approaches, taxes -- subsidies that businesses receive are added to income-based GDP

Depreciation

Like indirect taxes, must also be added to the income approach

Includes durable assets such as buildings, equipment and tools that eventually wear out and need to be replaced

Considered a cost of business and shows up in the expenditure approach

Statistical Discrepancy

GDP figures are actually estimates due to businesses/persons records being faulty or missing

The discrepancy between the two approaches is known as the statistical discrepancy

This can be seen in Figure 10.3

Breakdown of Figure 10.3

To balance the two figures, Statistics Canada divides the difference between the two approaches

Discrepancy was $4.8 billion. Half the amount ($2.4 billion) is added to the lower figure (income-based estimate of GDP), and half is deducted from the higher figure (expenditure-based estimate of GDP)

The Expenditure Approach

GDP found using this approach is the sum of purchases in the product markets

Categories of Products

Final Products: products that will not be processed further and will not be resold

Intermediate Products: products that will be processed further or will be resold

Ex: Flour that is bought by a household for home baking is a final product. Flour that is bought by a bakery to make bread to be sold is an intermediate product

Double Counting

This occurs when the values of all products, both final and intermediate are included in the GDP calculations

Would cause estimates to be too high & not reflect the real activity in the economy

End of Day 1

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Value Added

In order to prevent double counting, the concept of value added is applied to the GDP

Value Added: the extra worth of product at each stage in its production; a concept used to avoid double counting in calculating GDP

Figure 10. 4 uses a pad of paper at each level of production, the results of double counting and how the concept of vales added deals with it

Categories of Purchases

Recall that expenditure -based GDP is calculated on the basis of almost all purchases in the Canadian economy

Few products are excluded

Those that are included, fall under 4 distinct categories

Excluded Purchases

There are two types of excluded purchases: financial exchanges and second-hand purchases

These are excluded because they are not related to current production

Financial Exchanges

This includes a gift of money between family members and is not included in the GDP

This is a transfer of of purchasing power from one party to another

Also excluded are bank deposits and purchases of stock

Second-Hand Purchases

A.K.A, used goods Excluded from GDP because they have been

accounted for previously in their very first transaction to their original owner (first consumer)

In brief, if they were included, GDP would double count and thus overestimate

Included Purchases

Included in the GDP calculations

1. Personal consumption (C)

2. Gross investment (I)

3. Government purchases (G)

4. Net exports (X-M)

Each contribute to the the economy

Expenditure Equation

GDP = C + I + G + ( X - M )

Personal Consumption

Household spending on goods and services.

Make up 60% of the GDP

Goods include: nondurable and durable

Nondurable: goods that are consumed just once. Ex: food

Durable: goods that are consumed repeatedly over time. Ex: bikes and CD’s

Gross Investment

Purchases of assets that are intended to produce revenue.

Makes up 15-25% of the GDP year-year Most important spending in this category is on

capital goods (machines etc) used by businesses

Also included are expenditures by government agencies into capital goods

Gross Investment Cont.

Related to the economy’s capital stock The total value of productive assets that provide a flow of

revenue Recall that capital such as machinery depreciate in value Net investment is the gross investment minus

depreciation Represents the yearly change in the economy’s stock of

capital Capital stock is the total value of productive assets that

provide a flow of revenue

Breakdown of Fig. 10.5

An economy has $200 billion of capital stock at the beginning of the year

It depreciates by $40 billion during the year Gross investment during the same period is $100

billion thus the net investment is $60 billion (100-40) The $60 billion represents the amount that the

capital stock expanded during the year Thus by the end of the year, the economy’s capital

stock is $260 billion (200+60)

Gross Investment Cont.

Also includes: inventories of different companies stocks of

unsold goods and materials Building construction with owner-occupied

housing Included here instead of personal

consumption because the owner could rent it out for a profit

Government Purchases

Include current spending by all levels of government on goods and services

Make up 20% of GDP Ex: The federal government buying a

battleship for the Navy, or a municipality hiring a paving company to repair roads

Fig. 10.7 shows the role of government in the economy’s circular flow of money

Net Exports

Final category of purchase and includes the purchases of Canadian goods and services by foreigners, or exports

This is calculated via the exports -- imports This is done because while exports include an American

furniture store buying Canadian softwood, imports include a Canadian paintball player buying an American paintball gun

Represented as net exports, they make up a small % of GDP, yet viewed independently of each other, they each make up about 25% of the GDP

Breakdown of Fig. 10.8

Shows the roles of exports and imports in the economy

Foreigners also play a part in the economy by lending/borrowing from financial markets

Foreign involvement tends to create a net increase in the economy

Foreign loans to the Canadian economy > Canadian loans to foreigners

GDP and Living Standards

GDP can be used to determine our standard of living via per capita GDP

This is the GDP per person and is calculated as GDP/population

In short, per capita GDP is the total $ value of output per person

Ex: in 1993 our GDP was $710 723 million and our population was 28.753 million. our per capita GDP was $24, 718 per person

Adjustments to Per Capita GDP

Adjusted depending on how it is to be used

Inflation adjustments

Exchange-Rate Adjustments

Inflation Adjustments

Takes into account the effects of inflation when analyzing the economic well-being within a country

Done by using real GDP GDP expressed in constant $ from a given

year Per capita real GDP is calculated the same

way as per capita GDP but using the real GDP

End of Day 2

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Exchange Rate Adjustments

Used to help better compare per capita GDP between countries where currencies differ

To counter this, all countries GDP’s are expressed in one currency; American $

Limitations of GDP

Recall: GDP is a measure of the total $ value of all final goods and services produced in an economy over a given period

Indicates economic activity and living standards (to some extent)

Has quantitative and qualitative limitations Does not tell us about what is purchased or

produced

Excluded Activities

GDP does not include some types of productive activities meaning that the GDP can actually understate economic activity and living standards

Non-market activities: productive activities that take place outside the market place such as housework, unpaid child care and the work of “do-it-yourselfers”

Have vital impact on our living standards

Excluded Activities Cont.

Underground economy: all the productive transactions that go unreported

Include things such as smuggling or “under-the-table” transactions

These are transactions paid for in cash so as to avoid applicable taxes

Product Quality

With the introduction of new technology and an increase of living standards, the quality of our goods has increased dramatically over the years

GDP can only add up selling prices, cannot fully capture these quality improvements

Composition of Output

Refers to the different uses of GDP between countries

A country that dedicates its GDP towards to health care and education would have a much higher standard of living than a country that dedicated its GDP towards military uses

Income Distribution

Recall that incomes may be distributed differently throughout the population

“the richest 1 per cent alone owned 40 per cent of global assets in the year 2000.”

Income Distribution Cont.

“The world's total household wealth amounted to $125 trillion in the year 2000, a sum which, averaged out, should give every adult $20,500. But in some countries, average per capita wealth was below $2,000, while the richest ranked many times higher.”

Source: World's assets tightly held: Study by Olivia Ward. Excerpt from the Toronto Star

Leisure

Many people consider this important to living standards

Despite the fact that we are able to work every hour of the day, people do not

The hours worked per week has decreased dramatically over the past century

Leisure Cont.

GDP has no way of representing this change in working hours per week

This would indicate in increase in the standard of living

Furthermore, leisure is not a commodity and thus cannot be bought or sold on the market

The Environment

GDP does not differ between economic activities that harm the environment, and those that don’t

May not accurately represent spillover costs and benefits

Ex: the cleaning up of an oil spill would be added to GDP, the creation of a new nature preserve would likely not be added

Gross National Product (GNP)

The total income acquired by Canadians both within Canada and elsewhere

Recall that GDP focuses on the incomes made in Canada while GNP focuses on earnings of Canadians

In order to calculate GNP, 2 adjustments must be made to GDP

Calculating GNP

1. Income earned from Canadian investments by foreigners is deducted from GDP

i.e.: interest payments on a Canadian government bond held in Japan

2. Income earned from foreign investments by Canadians is added to GDP

i.e.: a stock dividend from an American company paid to a Canadian sharholder

Calculating GNP Cont.

The 2 adjustments can be made in an investment income account

Foreign investment in Canada is higher than Canadian investment in foreign countries

GDP -- the account shows net investment income to foreigners = GNP

Net Domestic Income (NDI)

Recall from CH. 8 that NDI represents what is earned by households supplying resources in Canada

NDI = GDP -- amounts that are not earning from current production

i.e.: indirect taxes, depreciation allowances, statistical discrepancy

Personal Income

The income actually received by households

Calculated via adjustments made to net domestic income

(Refer to 10.10)

Transfer Payments

Government payments to net domestic income

Unrelated to earned income

Received by households

Excluded from net domestic income, but are part of households’ personal income

Other Payments to Persons

Primarily from governments to households

Most important of which are interest payments paid by governments on the debt they owe

Not part of resource earnings but are received by households

they must be included in personal income

Earnings Not Paid Out to Persons

Include taxes on corporate profits and retained earnings

These items must be subtracted from net domestic income to find personal income because they are earned, not received by households

Net Investment Income to Foreigners

Recall how foreigners invest into Canada and is represented by a net investment account

This net investment income must be subtracted to give personal income

The income payments are post of GDP and net domestic income

They are not received by households

Disposable and Discretionary Income

Disposable Income: household income minus personal taxes and other personal transfers to government

Used to buy necessities such as food, housing and clothing

Discretionary Income: disposable income -- purchases of necessities

End of Day 3

Thank you and we hope you enjoyed our presentation!